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Disentangling the Economic Uses of Bitcoin as Currency

Jamus Lim's picture

Unless you've been sleeping under a haystack, you almost certainly would have heard of the wonderful promises of the cryptocurrency Bitcoin (PDF). While it's not necessary to go into the technical details here,[*] it's worth noting three key technological innovations built into Bitcoin. First (and foremost), it resolves the so-called Byzantine Generals' Problem of (broadly speaking) helping coordinate trust in a distributed communications network. The next two innovations are actually byproducts of the manner by which Bitcoin tackled the first issue. Since Bitcoin's approach to controlling denial of service attacks requires proof-of-work, it serves to simultaneously constrain currency inflation. And in effecting secure digital exchange, Bitcoin builds on long tradition of public key cryptography, which also serves to guarantees authenticity and prevent counterfeiting.

Bitcoin's solution to the Byzantine Generals' Problem uses a publicly-verifiable block chain, which (loosely speaking) is like an electronic ledger embedded into every new Bitcoin transaction.[] This ledger ensures that there is no double-spending of currency, and so allows us to trust anonymous exchanges without the need for a trusted third party. The proof-of-work Bitcoin uses calls for CPU time, which participants in the system can offer via so-called Bitcoin "mining." (it's worth noting that Bitcoin intentionally imposed a maximum number of Bitcoins---21 million---and in so doing made the process of mining exponential; that is, earlier coins are far more easily mined than later ones). Finally, Bitcoin rendered public keys anonymous, which (arguably) affords us the same level of privacy as physical cash.

It is important to recognize that the mining and anonymous public keys are actually economic side benefits (or main benefits, depending on how you may be inclined), secondary to the primary economic benefit of Bitcoin being a low-cost,[] trustworthy currency. Put another way, the exponential proof-of-work and anonymous public key cryptography inherent in the Bitcoin protocol are additional features that are not, strictly speaking, necessary for Bitcoin's to function as a currency. For instance, one could imagine a change in the Bitcoin protocol to allow linear average proof-of-work; or perhaps a pseudo-anonymous public key algorithm (which some have already argued is the current state of affairs).

Which brings us to one of the potential legacies for the electronic currency, especially for developing countries. Even if Bitcoin fails to take off---and the (il)legality of the cryptocurrency is indeed challenged in a number of large developing countries---it is useful to not lose the forest for the trees (or the bills for the coins, as the case may be). What probably makes many developing-country monetary authorities uncomfortable about Bitcoin is that Bitcoin opens possibility that it operates as currency in monetary systems that may not be able to successfully deal with parallel currencies. Yet this discomfort is generally premised on Bitcoin's primary use (as a currency). This suggests that it is possible to continue exploiting the other technological innovations inherent in Bitcoin, subject to tweaks.

Consider the possibility that an alternative system---call it DevDollar---with a less constrained proof-of-work mechanism and weaker embedded anonymity. Building on the legacy of Bitcoin, DevDollars could overcome the concern that monetary authorities have about the need for flexibility in expanding the money supply. Subject to reasonable privacy mechanisms, a pseudo-anonymous currency would allow law enforcement to more easily trace nefarious uses of the digital exchange medium. Finally, the extremely low transactions costs afforded by secure digital currency could leverage of the popularity of mobile cash in developing countries. In effect, DevDollars could offer a number of key benefits of currency---a secure medium of exchange, a reasonably unit of account, and decent store of value---without the suspicions that development policymakers may carry about an extralegal monetary unit. Put another way, a cryptocurrency that compromises (but does not fully eliminate) some of the most stingent conditions associated with Bitcoin could find more purchase in contexts where key economic institutions need to be somewhat more flexible in order to better cope with the conditions on the ground in developing countries.

*. A nontechnical, but sufficiently substantive, explanation of the problem is available here.

. More strictly speaking, the most recent transactions are recorded in blocks, which contains a hash---a unique string of numbers that summarizes a larger amount of data---of the previous block. Stringing together the blocks views the block chain, or complete transactions database.

. Using Bitcoin is currently free, so the costs of using the cryptocurrency are mainly opportunity costs stemming from limited counterparty acceptance, and the CPU time (and associated energy costs) of Bitcoin mining.